Tag Archives: financial analysis

A few weeks ago I was looking over the Morningstar.com tearsheets for about forty different mid-to-large-cap companies on a small assignment for an acquaintance. The project involved looking at the major financial metrics for a number of companies as provided on these tear sheets and trying to develop a quick, summary opinion of their business performance over the last decade.

On the one hand, it was just a bunch of series of numbers, going up, going down, sometimes not going much of anywhere at all. Depending on the metric being examined, this might be good, bad or ugly. But, if you looked a little closer, you might realize that even these simple numbers could tell a larger story about the business and what was happening to it or with it over time. You see, every financial metric I looked at was merely the result of the interplay of two, three, four or more other numbers “beneath” it. As one or some of these numbers changed, so, too, did the “top level” metric I was looking at on the tearsheet.

I spent a considerable amount of time, specifically, looking at the income and cash flow metrics, the reason being that most of these were large, stable and often growing enterprises– the balance sheet is always useful but with these kinds of companies what happens to income and cash flows over time can be an even more exciting and compelling story.

When analyzing an income statement, there are three key profit measures that investors like to look at: gross, operating and net profits. Additionally, when examining the balance sheet for the cash generating abilities of the business, there are two key measures investors focus on: operating and free cash flows.

If you’re like me, you sometimes forget the simple relationships these metrics have with other financial statement figures in terms of how one number drives another. Or maybe you’re new to studying financial statements and are looking for a handy reference. Either way, the following information may be helpful for you.

Let’s start with the income statement metrics:

Gross Profit, equal to total revenues minus the costs of goods sold; because of this, higher gross profits are arrived at by either increasing the price at which goods are sold (making revenues larger) or decreasing the costs of the goods sold (making COGS smaller)

Operating Profit, equal to gross profit minus the expenses incurred in running the business, such as paying sales costs (marketing, advertising, commissions), employees salaries and bonuses and corporate administration (SG&A), using PP&E and incurring depreciation or amortization expense and any costs related to the development of new products and services (R&D); because of this, higher operating profits can be achieved by lowering R&D expenses, lowering SG&A expenses, lowering D&A expense or raising gross profits by one of the methods discussed previously

Net Profit, equal to operating profit minus interest expense and tax liability; because of this, higher net profits can be achieved by minimizing tax expenses, reducing financial leverage and the interest burden that comes with it (or by refinancing existing debt at a lower rate), or raising operating profit by one of the methods discussed previously

If you are examining a series of income results for a company over a period of years and notice a variance in any of these primary profit metrics, look to the component drivers of those metrics to help explain the reason for the variance.

Free Cash Flow, equal to operating cash flow minus total capital expenditures; the less the company invests in maintenance and growth expenditures of capital now, the higher free cash flow will be, but if not enough is spent to protect the business’s earnings power and market position, long-term free cash flow generation abilities may become impaired

The operating cash flow metric is important to look at because it tells you whether the company actually generates a positive cash return on its investments from its main business activities. Companies that can’t generate cash from their operations over time are destined to financial and economic failure. Changes in operating cash flow when compared to changes in net earnings can give a window into how the company is generating profit– through business and market management, or through accounting manipulation and trickery.

The free cash flow metric is valuable because it shows the resources the company generates, beyond those needed to grow and maintain its current capital investments, which can be used to reduce indebtedness or reward shareholders with buybacks and dividends. Companies with relatively high and sustainable free cash flow-generating characteristics can be rewarding investments over long periods of time if they can be bought at low multiples to their normalized free cash flow.

There is a lot more to financial analysis than this. There are hundreds of ratios, metrics and other financial data you can use to measure the operating efficiency and management talent of companies you are interested in. This is not meant to be a comprehensive review. It’s possible I even missed a few items of note with regards to the metrics I singled out.

But sometimes I forget these simple truths when trying to think deeply about businesses I am analyzing, so I wanted to leave this little note for myself in case I ever get stuck and forget the obvious again. With any luck, this information will help someone else out in a similar fix, or else it will prove to be a stepping stone for a beginner making their first inquiry into the world of business analysis.

I’ve had a little back and forth with some other value investors recently on my concerns about some of DreamWorks Animation’s outstanding corporate governance and capital allocation issues. I figured it was probably time to put pen to paper and formally record some of these thoughts.

Capital mis-allocation

To start, I want to mention the capital allocation issues. Over the last four years (2008-2011), DWA generated approximately $508M in operating cash flow, or about $127M/yr. In that same period, DWA invested $217M in their business, or about $54M/yr, while it bought back $389M, or about $97M/yr, worth of stock and finally they retired $73M worth of debt, which occurred in one year (2009) and represented the last of their LT debt on the books at that time.

As you can quickly surmise, there was only $291M of FCF or about $73M/yr over that period to support $462M in buybacks and debt paydown, a deficit of $171M which appears to have been financed by drawing down cash on the balance sheet and potentially leaning on the revolving credit facility as well.

I see a couple problems here:

This is a growth company but the company will not be able to finance its growth ambitions on its own now because it has used a ton of its own financial resources buying back stock, which means it’ll have to either issue substantial new equity at low prices or take on more debt to finance its future growth

The buybacks occurred at a range of prices and therefore market valuations of the company, with many of them clustered at the high end of that range, implying the company is not good at determining its own value and buying back only when the company is on sale

The first issue concerns me especially so given the nature of DreamWorks Animation’s business– in the end, it is highly speculative and could easily fail, meaning the most appropriate financing type is equity, not debt. Debt is more appropriate for a low-risk, predictable, consistent enterprise (such as financing a real estate venture). Equity provides the kind of flexibility and endurance one needs to weather the potential storms in a business like DWA’s.

But by using up much of its cash, DWA has put itself in the position where it will have to either dilute existing shareholders at potentially disadvantageous prices, or else it’ll have to raise debt which I believe adds substantial extra risk because of the way it mismatches with their business fundamentals.

The second issue concerns me because I think it directly explains a lot of the apparent value destruction that has occurred at DWA over the last 4 years as communicated by the fluctuating market capitalization and I think it sets a precedent that is in the long-run bad for minority shareholders, not good, as people of the “buybacks are good no matter what” school of thought seem to believe.

In 2008, the peak price of DWA was $32/share and with 91M FDSO at the time, that amounted to a market cap of $2.9B. In early 2010, the company climbed to an all-time peak price of nearly $43.50/share and with 87M FDSO that amounted to a market cap of nearly $3.8B. The shares now linger back below their 2009 low of $18.56/share and very close to the all-time low of $16.52/share reached in January of 2012, trading around $17/share for a total market cap of about $1.43B.

Slice it how you like it but according to the market the company has conservatively destroyed almost $1.5B of value in that time and I’d say that’s primarily due to spending $460M on buybacks and debt reduction that could’ve been spent on growing the business or waiting for opportunities to grow the business. If you add that capital back into the business you’d get a market cap closer to $2B right now.

Most of the buybacks occurred near the $30/share range with relatively little of the buybacks occurring near the lows of around $17/share. This kind of capital allocation “discipline” can not be put to bed by arguing that “share buybacks are good if they happen at all”– the latter price represents a 50% discount to the former (or the former a nearly 100% premium to the latter, depending on how you want to look at it)! Are we supposed to be comforted by the fact that DWA’s management and board seem to think the company is cheap anywhere between $3B and $1.5B in market cap?

That isn’t a reasonable way to manage capital. You’ll never catch Warren Buffett making that kind of argument and I highly doubt you’d have much money to manage on your own if you adhered to that philosophy for long.

One of the replies I got back from another investor (see below) on this was that “what’s done is done.” That is an unacceptable response. What’s done is not done because it could very easily happen again and it is more than likely to do so given that the pattern set, the discipline demonstrated so far, is that the management and board of DWA is incompetent when it comes to allocating capital to share buybacks. This is a red flag and a way they could continue to destroy whatever value they create through their growth strategy in the future.

Golden parachutes for the pilot and the flight crew, but not the passengers

At the behest of another money manager with a value-based approach I had been communicating with, I decided to review the Form DEF-14A filed 4/11/12 for DWA. I had (admittedly) skim-read the thing when first performing due diligence several months ago, but I had not read it line-by-line as he had urged me to do, more on that fact in a bit.

As I read through it, I noticed a few things.

For one, I noticed that FRMO-owned companies own 9,614,089 shares or 13.1% outstanding, ostensibly for their ETF products. From a recent post here at valueprax you’ll remember that I am impressed with the strategic thinking of this organization and for the purposes of their own business they seem to be great capital allocators (of course, I have no idea at what prices they accumulated their position). But then it dawned on me that most of their products are passively-managed index ETFs and that took the wind out of my sails. I’m not necessarily under the impression at this point that they hold a stake because they think it’s a great buy, but just because it fits some strategy or theme for one of their proprietary indexes. So, that’s about 13% of the company potentially owned by “dumb money” in this case.

Then I noticed that the company utilizes Exequity and Frederic W. Cook & Co., compensation consultants, to determine executive pay. I’m working on a “digest” post of articles I’ve been reading about corporate governance and activism over at a now-defunct website nominally belonging to Carl Icahn (man, that guy seems a bit ADD at times the way he starts and stops investments, grass roots activism platforms, etc.) and I came across this post on compensation consultants which really set off alarm bells for me.

Think about it for a second– the managers are using company money, which belongs to shareholders, to hire consultants (multiples in this case) who charge millions of dollars and spend hundreds of hours trying to outdo each other in justifying outlandish executive compensation packages. In other words, they use your money to figure out how much they should pay themselves at your expense. It’s kind of like gilt-edged unionism for corporate executives. Why the hell is this such a mystery? Why do you need consultants to figure stuff like this out for you?

This is a corporate governance red flag– this is not treating minority shareholders like equal partners but rather treating them like the sucker at the table. After all, Katzenberg owns about 15% of the company and because of the dual class share structure (another red flag, by the way), effectively controls the company himself which makes him an owner-operator (to be fair, a good thing)… you think he can’t figure out how much to pay his other executives in terms of what’s good for K-man and what’s not?

Preposterous!

Then I get to the actual executive compensation itself. Katzenberg is now paid a $1 annual salary, choosing to receive most of his compensation via stock options and other perks. Other executives are compensated quite generously and compensation has been growing. The value of options grants is $17M annually, or over 1% of market cap each year. Long-term incentive compensation is worth another $9.2M. Combined, that is $26M or almost 2% of the company’s market cap for a handful of top execs and board members.

Other things of note:

Lew Coleman, president and CFO, recently exchanged higher annual cash salary structure in return for decreased long-term incentive awards, does this show lack of faith in the long-term value of the company?

Ann Daly, the COO, has part of her compensation tied to performance of the company’s stock price, which is an idiotic practice given that it incentivizes her to manipulate the company’s operations to game short-term numbers meanwhile the company’s management has no direct control, in the long-run, over what the investing public thinks of the value of the company (yes, their actions will translate into better or worse valuations but in the end it’s like tying someone’s compensation to the weather)

Overall, tons of golden parachutes for just about everyone in the case of a change of control or a termination with or without cause, which are more blatant red flags and give minority shareholders an unfair shake

Then there’s the income tax savings-sharing agreement with Paul Allen, a former shareholder and financial enabler of the company which the proxy explains constitutes “substantial” payments to Mr. Allen over time (this fact being confirmed by the multi-hundred million dollar payable on the balance sheet). To put it simply, I don’t get this or how it works and so far no one has been able to explain it to me. It could be harmless, it could be disastrously unfair to minority shareholder. I really have no clue, it’s beyond my accounting and income tax liability knowledge.

My overall impressions were thus: it takes 66 pages to explain/justify DWA’s compensation practices and related-party special transactions. The company hires compensation and other consultants with shareholder money to determine what management should be paid. And shares are locked up and all change of control decisions will be made by Katzenberg. This company gets maybe a C in terms of corporate governance, which is average in relative terms but sucks in my absolute opinion.

In general, I am concerned about my own ability to understand the accounting behind the company’s compensation practices. And this dovetails with my lingering concern that neither I nor anyone else seems to be able to confidently and accurately model just how much cash specific or even any single movie title in DWA’s library generates for the company at different points over its life.

Bringing it full circle

A few days ago I posted a video interview of Rahul Saraogi, a value investor operating in India, along with my notes of the interview. I found the interview surprisingly impactful (I’ve been watching other interviews from the Manual of Ideas folks and unfortunately none of them have come anywhere close in terms of profundity) and the item that stuck out the most from the whole thing was Saraogi’s comments on the importance of corporate governance and capital allocation for the long-term investment results of minority shareholders.

To reiterate, according to Saraogi good corporate governance means dominant shareholders who treat the minority shareholders like equal partners, who do not treat the company like a personal piggy bank or a tool for furthering their own personal agendas at others’ expense. He says good corporate governance is binary– it either exists or it doesn’t, there are no shades of grey here. The issues I’ve cited above make it clear that DWA does not have good corporate governance practices. The fact that the Form 14A discloses the fact that both David Geffen and Jeffery Katzenberg are essentially using the company resources to the tune of over $2M per year to subsidize their ownership and maintenance of private aircraft is another good example– it is one thing to have the company reimburse them for expenses occurred in doing business but it is quite obvious from the way this agreement is structured that the company is basically paying for the major costs of ownership while they are deriving the personal benefits and exercising discretion as owners in name and title.

Similarly, capital allocation is critical in Saraogi’s mind and many companies and their management don’t get it– they either don’t understand it’s importance or how to do it, or they don’t care because they’re rich enough. I think a little bit of both is operating here. Certainly Jeffery Katzenberg is “rich enough” at this point. He’s worth several hundred million dollars at least, he has the company paying for his private aircraft and other perks and he has even said in interviews I’ve read that he’s got all the money he could need or want at this point and continues to work out of passion and interest. Normally that’s a good thing but in this respect it’s a bad thing because a person who operates as an artist rather than a businessman probably doesn’t care what their ROC looks like as long as they get to put their name on the castles they build.

And people who get capital allocation don’t pay prices that range nearly 100% in value for shares they purchase, unless of course they’re absolutely convinced the intrinsic value still far exceeds such prices. I note here that while there is no evidence from the company that this isn’t the case, there’s similarly no evidence that there is, and I don’t think faith is a good basis on which to form a valuation. As an aside, none of the grade-A elite Wall St analysts on the earnings calls ever ask about this, and my e-mail to DWA’s IR on this topic and numerous others went completely unanswered, which is another embarrassing black mark for the company in terms of corporate governance.

I really enjoy Whopper’s blog for the most part but I consider these two posts to be some of his weaker analytical contributions to date (which should be obvious from my remarks in the comments section of each, 1 and 2) and if anything that makes me even more queasy with this one– he mimicked a lot of my own unimpressive reasons for investing and I don’t generally find the sound of my own voice that soothing in cases like these, and he seemed unable to answer some of my deeper concerns, which could be evidence of his own shortcomings as an analyst or it could be evidence that these are questions with unsatisfactory answers by and large (I prefer to believe the latter at this point).

In a nutshell, at this point my major concern is that, even if the company successfully executes on its grand growth strategy it might not mean as much for minority shareholders as we might like due to outstanding corporate governance and capital allocation concerns. I seriously wonder if I and many other value investors like me are not blinding themselves to these “binary” concerns because the potential home-run hit possibility of getting in near all-time lows on “the next Disney” is just too exciting to resist.

Whatever I do, I’ve now written this post and put it in the public domain so I won’t be able to excuse myself later on by claiming I hadn’t thought about these issues.

A little back and forth between Nate Tobik and I about a company I have been analyzing resulted in Nate directing me to a post he had written on an ROIC metric he likes to use. After reading the post, I liked it enough myself that I want to copy the metric, composition and reasoning to my blog with this post so I have it for future reference.

Intangibles are included because they represent real cash outlays used to purchase cash-producing assets

IBD is included because it serves to help acquire cash-producing assets as well

PV of operating leases because these leases are essentially debt that helps produce a cash return for the business; excluding them would unfairly boost ROIC and distort return comparisons between companies that lease property versus buy it outright

FCF includes the payment of cash taxes and the elimination of other non-cash accruals

There’s more information on this metric and a fuller discussion of its benefits and drawbacks at Nate’s original post.

A “valueprax” review always serves two purposes: to inform the reader, and to remind the writer.

Distressed debt: a true contrarian investment strategy

The following note outline was rescued from my personal document archive. The outline consists of a summary of Stephen G. Moyer’s integral handbook on distressed debt dynamics, Distressed Debt Analysis. The notes currently cover chapters 1-4. They are incomplete at present. I will likely not revise these notes and instead plan to release a new series of notes on this book in the future when I re-read it.

Distressed Debt Analysis

Chapter 1 – Introduction

What is “distressed debt”

Some define based off of credit ratings, which lacks rigor because:

credit ratings lag fundamental credit developments

credit ratings essentially only handicap the risk of default, they say nothing of whether the price is appropriate for the risk

Martin Fridson advocates defining debt as distressed when it trades with a yield to maturity greater than 1000 basis points more than the comparable underlying treasury security

Moyer suggests the following:

equity value is diminimus (eg, under $1/share)

all or some portion of unsecured debt trading at a market discount of more than 40%

this pattern implies a balance sheet restructuring, resulting in creditors owning a significant portion of equity, or else a sale of assets and subsequent liquidation

EMT theory suggests the market can be relied upon to accurately asses the value of assets and thus one can infer the value of a firm’s securities

in reality, the market makes dramatic reassessments of securities, positive and negative, often with very few fundamental changes in the business

declines in asset value can be handled fairly flexibly when the capital structure is composed of equity; when the capital structure is composed of large amounts of debt this becomes tricky (due to debt covenants)

two solutions

increase the value of the company (unlikely possibility or management would’ve done it)

resize the capital structure

resizing is accomplished via the restructuring process, a combined legal and financial operation

Chapter 4 – Legal OverView of Distressed Debt Restructurings

OUT OF COURT RESTRUCTURINGS: THE PREFFERED OPTION WHEN EFFECTIVE AND FEASIBLE

The Financial Effects of an Out-of-Court Restructuring

Firm and its most significant creditors negotiate a change in the terms of obligations or a voluntary exchange of financial interests

debt for equity or reduced debt for new debt and equity are typical arrangements

the postreorganization capital structure is fairly “arbitrary”; the company may eventually flourish under a number of different capital structures

because it is not handled in court, this settlement can not change or negate the interest of other claimants not participating in the restructuring

the restructuring can involve payments of cash instead of exchanges of securities

The Out-of-Court Restructuring Process

Parties Involved

With bank debt, the negotiating agent is usually self-evident and is often a previously chosen “agent” of a loan syndicate specified in the loan agreement

With bonds, typically represented by a small group of significant bondholders who form an informal bondholder committee, in practice >=25% of all bonds

There are often agendas involved; commonly people are united around the cause of achieving the most economic value from their claims as possible, but opportunists might see a way to cheaply “acquire” equity which might be profitable in the future

The view of the “job” of forming a bondholder committee is subjective; a hedge fund may see it as an intended part of the investment; a mutual fund or insurance company might consider it to be an embarrassing but necessary evil

The bondholder committe has no legal authority to bind either member or nonmember bondholders

Strategic Considerations in Participating on the Bondholder Committee

If the objective is to invest so as to participate in the bondholder committee, one must be prepared to accumulate a significant quantity of the bonds

an investor may be forced to sign a “confi” (confidentiality agreement); the investor gains the best material information available but must make disclosures of possession of such information (but not the info itself) when trading, which could make trading more difficult

restriction begins at the receipt of material non-public info and ends when the information becomes non-material or is publically disclosed via an 8-K, 10-Q or 10-K

counter-parties which have become restricted must execute a “big-boy letter”

an acknowledgement by the nonrestricted party that they are aware the counter-party has material non-public info

a waiver of claims the nonrestricted party might otherwise have under securities law

typically executed by a broker-dealer to maintain anonymity

Beginning the Process

when the debt is bank debt, usually begins because the borrower is in or approaching technical default of some provision of the loan

when the debt is bonds and there is no or little bank debt, an investment bank or other restructuring specialist is often hired on retainer for advice

if out-of-court looks like an option, the firm can

invite creditors to organize a bondholders committee

propose a restructuring without prior consultation

Implementing the Restructuring

with bank debt, usually involves an amendment to the loan agreement

with bonds and a bondholder committee, usually a relatively simple private exchange

Feasability: The Holdout Problem

those not participating in the restructuring may be better off than those who do, but if nobody participates, all will be worse off

with too many holdouts, the company’s only option is bankruptcy, which often just adds legal costs and reduces everyone’s final recovery

holdouts may be managed via:

moral sanction– the distressed debt market is small and the big players are well known so most deals happen within a context of familiarity and consideration for the future of relationships

coercive structural devices– use of tender offers to strip out covenants on the holdouts, forcing them to participate

IN-COURT RESTRUCTURINGS: AN OVERVIEW OF THE BANKRUPTCY PROCESS

Intro

it is hardly ever a surprise when a firm files for bankruptcy

market prices have typically adjusted prior to the filing to represent the fear and uncertainty

many firms send signals and warnings to the market before doing so

distressed debt situations are often illiquid and you can not wait for the “bottom” to accumulate a position

some or all of the creditors will usually incur some financial loss

the key is not to buy at the bottom but to buy for less than things are worth

Declaring Bankruptcy

begins with a petition filed at a bankruptcy court, filed by the debtor and known as a “voluntary petition”

in a few cases, three or more creditors may have grounds for filing an “involuntary petition”

Chapter 11 contemplates allowing the existing management to reorganize the debtor as a going concern

Chapter 7 anticipates that a court-appointed trustee will supervise the liquidation of the debtor’s assets

Jurisdiction of Filing

if a prepackaged plan has been put together, a jurisdiction with a reputation for expediting the process may be chosen

if management anticipates a fight with creditors, it might choose a more “debtor” or “home-town” friendly jurisdiction

DDI need to consider the relative level of bankruptcy planning that has occurred or may be possible, the probable jurisdiction of filing and what this implies for the timing of the resolution and the potential effect on the treatment of various claims

Timing of Filing

debtor will typically choose to file before it is in material breach of an agreement, which would allow creditors to make an involuntary filing

the debtor will often try to conserve or charge up liquidity prior to the filing by stretching payment to vendors and creditors and utilizing revolving lines of credit

everything that occurs before filing is considered “prepetition” and everything afterward is “postpetition”, which are senior to “prepetition” claims

when the management of the debtor continues to operate the business postpetition, it does so as fiduciary of the creditors, known as “debtor in possession”

tasked with managing day-to-day operation of biz

anything outside the scope of ordinary business, such as sale of a major asset, requires approval of the bankruptcy court

chapter 11, creation of “official committee of unsecured creditors”

appointed by U.S. Trustee under the Bankruptcy Code

supposed to consist of the seven largest creditors willing to serve

equity holders are allowed to participate in the process and vote on acceptance of the plan for reorganization in certain cases

The Goal: The Plan of Reorganization

Intro

plan of reorganization is a legal document that discusses what will happen to the debtor, its assets and all constituent liabilities, including equity interests, upon the debtor’s exit from bankruptcy

confirmation of the plan is a pivotal legal event which instantaneously alters, with significent uncompensated loss in most cases, preexisting legal relationships such as lending agreements, leases and other contracts

The Role of Exclusivity and Prefiling Coordination

in cases of significant cooperation, management and creditors may work out a tentative plan and have it readied for a vote before the bankruptcy petition, called “prenegotiated” chapter 11 filing

opposite end of the spectrum, an abrupt filing or one lacking consensus is called “free-fall” chapter 11

often a warning sign that the bankruptcy process may be especially lengthy (1-3yrs) and expensive

may signal the reorganization will involve a change of management, introducing a new element of risk

Content and Structure of the Plan

identifies claimaints and assigns them to classes for purposes of voting and priority

class usually determined by commonality of interest

similarity involves similar priorirty against the debtor

provides for what, if anything, each class will receive in the reorganization

all claims grouped within a class must be treated similarly

Operating Under Chapter 11

Stabilizing Operations

automatic stay freezes all creditors in their prepetition state

grants debtor some “breathing room” and financial flexibility

debtor-in-possession allows a super-priority interest against assets to be granted to postpetition lenders

rollup, conversion of a prepetition claim into a postpetition claim through an offer to become a DIP lender

critical vendor motion occurs when the bankruptcy court allows the debtor to pay critical vendors to allow for the continuance of business

KERP, key employee retention plans are often negotiated

Developing a Going-Forward Business Plan

downsizing the labor force, closing unprofitable facilities, selling noncore lines of business or assets and renegotiating various contracts are typical

making a new acquisition is not common although not technically prevented by the law

Determining the Assets and Liabilities

assets

voidable preferences are transactions and distributions that occurred before bankruptcy filing which need to be unwound

fraudulent conveyance, occurs when a debtor did not receive fair value in the transaction in question and at the time or as a result of the transaction was insolvent

debtor may be seeking assets through ongoing legal actions and complaints

laibilities

executory contract rejection and expunging of unexpired leases

Determining the Valuation and the New Capital Structure

“best interests test”, no creditor should come out with less in a reorganization than they would under a liquidation

Voting on and Confirming a Plan of Reorganization

a solicitation package is approved by the creditors and then sent to all holders of impaired claims and interests

for acceptance, 50% in number of claims representing 66 ⅔% of the amount must vote in favor

Summary

chapter 11 is the result of a failure to reach a consensual restructuring

bankruptcy proceedings are complicated and involve substantial negotiation and gamesmanship

the DDI must gain an appreciation for the other participants and their leverage

secured claims will have greater assurance of recovery but lower return potential

example of a non-security: fast food franchise agreement which requires the owner to participate as manager as part of the agreement

Understanding the underlying business becomes increasingly important as larger amounts of funds or increasing proportions of the individual’s resources are invested in a security

Additionally, understanding the business is increasingly important with diminishing seniority within the security hierarchy, which exposes the investor to increasing risk

The book takes a broad perspective on the strategies and perspectives of numerous types of investors because understanding the motives of others can highlight specific opportunities and risks for the individual investor himself

Emphasis is on “business internals” rather than market and economic externals

most individuals have little ability to predict the latter

keen awareness of the former can remove a lot of the risk from the equation and protect the investor from mistakes made about the latter

Disagree with modern capital theorists

most markets and common-stock prices are in disequilibrium

careful and thorough perusal of publicly available documents can guard the individual from unsystematic risk

Underlying conviction that the value of a business has no necessary relationship to the price of its stock

The primary determinant of future earnings and common-stock prices is financial position; quality and quantity of a business’s resources

“Magic formula” for investment success is not arithmetic but grows out of:

experience

insight

maturity of judgment

Three general topics covered by the book:

educate outside investors about the way insiders and deal promoters tend to think

help the outsider to gain familiarity with the uses and limitations of required disclosures of the SEC

attempt to impart understanding about the roles of the various players in the financial community and how they each participate in the investment process

Focus on four types of investments to be made in commercial paper, corporate bonds, certain leases, preferred stock, limited partnership interests and common stocks:

trading investments

investments in the securities of emerging companies or industries

workout and special-situation investments

cash-return investments

Chapter 2, The Financial-Integrity Approach to Equity Investment

Successful investors-activists prioritize their concerns as the potential issuer of a loan would:

First, how much can I lose?

Second, how much can I make?

Strong financial positions generally translate to:

less risk

greater ability to expand business

more attractive candidate for asset-conversion activities

Attractive equity investments for outsiders should have the following characteristics:

strong financial position, measured not so much by presence of assets as by the absence of significant encumberances

run by reasonably honest management and control groups that are aware of the interests of creditors and other security holders

availability of a reasonable amount of relevant information, necessarily falling short of “full disclosure”

price out to be below the investors reasonable estimate of net asset value

Primary motivation for buying is that values are “good enough”, no search for bottoms in the short-run

Shortcomings of the Financial-Integrity Approach

requires an enormous amount of work; sifting through documents

know-who is helpful and at times essential; special information discernible only from non-public relationships

the most attractive securities uncovered by FIA tend to be in inactive markets, especially postarbitrage

risk aversion results in a severely limited selection of attractive securities which might be fully enjoyed by the less risk-averse

securities issued by those believed to be “predators” should be avoided

FIA approach is mostly useless in areas where sufficient public disclosure can not be obtained

insiders sometimes pose a risk to outsiders and because of their ability to force-out outsiders and independently appraise values, some attractive opportunities will be avoided by the FIA adherent

FIA view of risk

quality of the issuer

price of the security

financial position of the holder

Chapter 3, The Significance of Market Performance

Stock market value should be weighted differently for different individuals

traders; 100% because they are trading for capital appreciation

investors seeking secure income; 0%, because they may want to acquire a larger position over time at lower prices

vast majority of people; somewhere considerably more than 0 and considerably less than 100

Investors who do not weight stock prices as 100% important:

investors who would benefit from low market valuations for estate tax or personal-property tax purposes

investors seeking to accumulate large positions for control or to influence control shareholders

One can not beat the market by trying to beat the market; instead, long-term performance comes from buying clear values and holding them in the absence of clear evidence that a mistake has been made

evidence for this mistake comes in the results of the business, not the market’s valuation of the business

Market performance is more important to a portfolio of fixed size or facing continued withdrawals of cash; less important to a portfolio which is a continual recipient of new cash and is thus a dollar-averager

for the dollar averager, good market perf results in less attractive terms for continued investment, bad market perf leads to more attractive terms for continued investment

dollar averaging diminishes the need to beat inflation because changes in the value of money, in the long-run, will be offset by changes in the return on securities

An outside investor holding a completely marketable security should give a weighting of close to zero to market perfomance when:

he knows has reason to believe that the security’s real worth is not close to the market price

he knows he will not need to liquidate in the near future

he knows he will not need to use the security as collateral for borrowings

Important to remember that stock market prices are not business or corporate values but a realization price that will likely not hold in the event of a merger or acquisition; market price is a value of only part of the total outstanding, not all outstanding stock

Comparative measures of portfolio performance are imprecise; a company can beat its industry benchmark but still have performed poorly in an absolute sense, or vice versa

Professional money managers and beating the market

some economists believe that the goal of professional money mgrs is to beat the market and they have failed if they don’t

many professional mgrs have other concerns than simply beating the market:

maintenance of cash income

maintenance of cash principal

for example, is it important that a strongly capitalized insurance company outperform the market when its net investment income is increasing at 10% annualized?

this theory is not sutiable for outside investors primarily interested in income, dollar averaging or special-situation investors who ignore timing considerations, as well as all activist investors

MCT also assumes the avg outside investor and his adviser are capable and able to interpret information correctly; empirical evidence points to the opposite

The computer and mathematical analysis

the fatal flaw of mathematical analysis is the non-quantifiable variables or ugly facts that get left out of the models assumptions

On systems for playing the market

Chartist-approach

Not necessarily irrational or illogical

Movements of the market do represent aggregate behavior, however, to date no truly successful chartist model has been created

Random-walk theorists

at any instant, price changes follow no predictable pattern

using only trading information, there is no predictability to prices

filtering rules or formula-timing

best that can be said is their mechanical application can save investors from getting suckered into go-go markets or being rushed out the exits by mass panic

On arbitrage

topic for a professional, requires plenty of calculation and minimization of trading costs (should be a member of an NYSE firm)

Thorpe and Kassouf’s book is recommended

Portfolio balancing

“Beta” is the estimated market sensitivity of a stock, measured in terms of an expected incremental percentage return associated with a one percent change in return of the S&P500

For the avg investor, problems occur far more often with security analysis than portfolio selection

Most important for someone running many millions of dollars; for everyone else, this is over-rated; all the best portfolio-balancing in the world won’t save you from poor analysis

Fundamental security analysis and corporate finance

Good fundamental analysis involves perception, training, understanding and a high degree of abstraction in implicit or explicit model building– picking the right variables and causal relations

There are far fewer skilled practitioners than there are opportunities to practice security analysis

The idea that fundamental analysis is not necessary because markets are efficient is flawed because most analysts are incompetent, which prices ultimately reflect

Calculation or evaluation

The problem facing any serious analyst is what the figures mean, not what they happen to be

For example, imagine a company carrying real estate on its books at $1.5M; the significance changes when we learn that they represent 100,000 acres of California coastal land carried at the 1880 purchase price

Valuations change depending upon the context of valuation; estate planning, income taxes, obtaining a loan, etc. all produce different valuations of the same entity

Chapter 5, Risk and Uncertainty

The outsider faces greater risks than the insider

he cannot acquire complete knowledge of a company, no matter how many documents he studies

he (and the insider) face the possibility that the analysis is wrong

he may fail to properly appraise the quality and honesty of the management

he may simply fall prey to the unpredictability of the future

the market may fail to realise intrinsic value for extended periods of time, even if the analysis of those values is correct

Assessing the investment odds: risk and reward

conventional wisdom states that the key to investment risk is the quality of the issuer

high quality issuers tend to be well-known, and this knowledge is reflected in asset prices

therefore, the cliche, “You have to take chances if you want to make money”

but financial position of the security holder and the price of the issue are also important factors in judging risk and reward

Quality of the issuer

A company can become high quality just because important people within the investment community say it is; they’re often proven wrong

never buy when a high quality company is being touted because it is probably overpriced then

if your investment matters to you, obtain at least a rudimentary knowledge of the company before investing

Price of the issue

Good investors focus on how much they can lose; “risk averse”

higher price translates to higher risk, lower price, lower risk

there can be considerably lower risk investing in a lower quality company at a lower price than at a higher quality company at a higher price

an investor with more time and expertise to spend on his analysis should weigh price considerations more heavily; an investor with less time and less expertise should weigh quality considerations more heavily

Financial position of the holder

an investor who buys the best quality stock at a fraction of its overall value is taking a significant risk if he can’t afford the purchase

investors on margin can turn high quality investments (such as USTs) into speculative gambles

investors often take losses when they do not have enough funds to live on and are forced to liquidate at an inopportune time

without the resources to ignore them, an investor has no guard against stock-price fluctuations

Portfolio diversification versus securities concentration

diversification is a way to reduce risk in situations where the investor lacks knowledge

in situations where the investor enjoys enough knowledge, confidence and financial position to weather temporary setbacks, the risk-reward ratio may be tipped in favor of concentration

Considering the consequences

The astute investor examines consequences as well as odds

The odds can be strongly in favor of appreciation/success, but the consequences of failure so severe (insolvency) that the risk-reward ratio is still not in favor of making an investment

Risk and investment objectives

The cash-return investor will base his investment decision on different factors in evaluating risk than the special-situation investor, even when using the same facts

Risk-reward ratio will provide the investor with a guide to use in defining his investment objectives

Cash-return investors with no opportunity to investigate carefully should focus primarily on quality of the issuer

reference bond rating services

reference the investors own independent conclusions

any doubts, don’t invest; sell if owned

should limit investments to debt securities in most instances

debt securities have a legally enforceable right to be paid principal and interest

higher up in the capital structure in the event of an insolvency

workout- or special-situation investor should focus on price of the issue

he finds safety in a low price

place important emphasis on the four elements of the FIA

Chapter 6, Following the Paper Trail

Principle documents of the paper trail:

Form 10-K; official annual business and financial report

Form 10-Q; quarterly financial report, includes disclosures of certain material and extraordinary events that occurred during the three-month period

Form 8-K; filed within 15 days of a reportable event, unscheduled material events or corporate changes

Annual reports; most important way most public companies communicate with shareholders

Quarterly reports

Annual-meeting proxy statements; used to solicit votes of shareholders

Merger proxy statements; issued to shareholders to vote on an asset conversion-matter such as merger, consolidation, sale of assets or liquidation (S-14)

Cash tender offer circulars; sent when a publicly announced offer is made to buy shares for cash

Encumberances are almost always spelled out in these documents and their footnotes

The documents and how to read them

Simply reading these documents will give you a good idea of whats contained within and what their use is

If you can obtain copies of the preparation documents used to create the SEC officially regulated forms, you can get an idea of what the preparer has to consider in making disclosures

Other important documents

Forms 3 and 4; disclosure by insiders concerning their shareholdings and changes in holdings

Form 144; filed by holders desiring to sell restricted stock under Rule 144

Form 13F; filed by all managers with accounts of marketable equity securities greater than $100,000,000

Schedules 13D; filed within ten days by persons who have acquired 5 percent or more of an outstanding security issue (or, who acquire an additional 2 percent within a 12 month period after already acquiring 5 percent)

Schedules 14D; similar to 13D, filed prior to making a cash tender offer for more than 5% of shares outstanding

What the paper trail doesn’t do

does not provide company forecasts, company budgets and valuation appraisals of assets

no real disclosure as to specifics of running the business, such as appropriate levels of capital expenditure, marketing, research and development, etc.

might miss small acquisitions that do not require a shareholder vote

Chapter 7, Financial Accounting

Types of accounting

cost (or control or managerial)

purpose is to tell a management what its costs are

internal, essential to the operation of the business

income-tax

not supposed to measure economic reality, unlike cost-accounting

designed to create an economic reality (tax bill) based on rigid set of principles (Internal Revenue Code)

emphasis is on minimizing tax exposure

financial

sandwiched between cost accounting and income-tax accounting

“primary purpose is to provide quantitative financial information about a business enterprise useful to owners and creditors”

seeks to “fairly” represent the results of operations and the financial position of the company

How to understand financial accounting, five major misconceptions:

no need to distinguish between financial accounting versus income-tax and cost accounting

financial accounting has much the same role in corporate analysis and in stock market analysis

primary emphasis in corp analysis is on what numbers mean, not what they are

in corp analysis, no rule that one accounting number is more important than any other; in stock market analysis, primary emphasis tends to be put on net income/earnings per share

in corp analysis, profit is thought to come from the business factors themselves; stock market analysis, profit comes from what one thinks someone else will pay for the security later

because stock market analysis doesn’t rely on deep understanding of the underlying business, value is sought elsewhere– in precise attainment of estimated numbers

accounting can be made distortion-free an/or realistic and/or uniform

financial accounting is based on Generally Accepted Accounting Principles

an attempt is made to match revenues with costs on an accrual basis to the exclusion of matching cash inflow with cash outflow

an attempt is made to view businesses on a going-concern basis

financial-accounting is primarily based on exchange prices

financial-accounting is primarily based on historical costs

financial statements are designed to be general-purpose, “serve the common needs of a variety of groups”

as a result, financial-accounting can not be distortion-free, realistic or uniform

financial-accounting is more useful at measuring the economics results and values rather than the solvency of a business

more useful for judging a strict going-concern

less useful for a natural resource company, real estate or life insurance companies or companies engaged in mergers, acquisitions and imaginative financing and refinancing

as an example, most high quality real estate that is well-maintained doesn’t depreciate over time, but it has to for tax and accounting purposes

about the meanings of GAAP

inter-industry distortions arise based upon calling similar circumstances “permanent differences” or “timing differences”

about the shortcomings of the corporate audit function and the ethical standards of independent auditors in the US

Chapter 8, Generally Accepted Accounting Principles

Myths and realities about the meaning of GAAP

Myth #1; GAAP tends to, or ought to, be rigidly codified with a series of well-articulated do’s and don’ts

Myth #2; GAAP is all-encompassing and is, or should be, designed to measure all sorts of corporate events and phenomena

Myth #3; GAAP should tell the Truth, that somehow it can be made more realistic for average investors while still becoming more informative and more useful for all of its users

Eleven underlying assumptions of GAAP which provide insights into its uses and limitations:

ownership of, that is, title to, tangible assets is the basis of value and the means of creating income

ignores the value of intangible assets, such as lack of debt or ability to create new debt, advantageous debt terms, price at which new equity can be raised, etc.

GAAP becomes increasingly less descriptive when intangibles play a larger role in creating value and income

GAAP provides good benchmarks to value the output of a steel mill, for example

GAAP does not provide good bench marks for valuing the worth of a medical degree

corporate asset items have independent values unmodified by their inclusion as but one small part of a going concern

as a practical matter, few assets of a going concern have value that is independent of the going concern

independent values exist only in asset-conversion

passivity and liquidity are highly interrelated; more liquidity means less responsibility in administering the asset

changes in accounting rules should not be disruptive of important existing practices unless there is conflict among establishment members

GAAP is an establishment tool and its basic purpose is to aid, not to fight or alter, an existing economic system

changes should be expected to be evolutionary, not revolutionary or radical

a puritan work ethic is desirable; hence achievement through going-concern operations are far more desireable than achievements through asset conversions– mergers and acquisitions, reorganizations or refinancings

profit should be created from going-concern operations, not capital appreciation through asset arbitrage

the medium is the message

immediate stock market impact is what financial statements are directed to

precise definitions are a desireable goal

as much as possible, items should be defined as expense or income, liability or proprietorship

except for insurance-company accounting, no recognization that many items (deferred income taxes, unexpired subscriptions, low-interest rate mortage loans, etc.) have elements of both expense and income, or liability and proprietorship

high book value relative to market price when price-earnings ratios are high results in low return on investment

companies with high profit margins, high stock prices and low book values attract comeptition

companies that survive and prosper in highly cyclical, unprotected industries tend to be run by able mgmts

Profit margins

low profit margins can be a strong reason for purchasing a security if it is believed the margins will improve; small improvements in low margin situations can result in big, leveraged returns

companies with consistently high profit margins tend to be popular and thus over-priced

it often happens that companies with consistently high profit margins suddenly lose them overnight

Size

small companies should be chosen because of the appreciation potential inherent in their prospects for growing into giant businesses

many small and medium sized companies are well financed and effective competitors, meaning they are high quality issuers even if not recognized as such

large firms are best selected by investors with no ability or time to get to know their investments better

in general, the smaller the business, the riskier, however, there are times when high prices can make large businesses riskier on a relative basis

Liberal accounting policies

a firm can use liberal accounting policies to gain market sponsorship through excitement about its strong earnings profile; this market sponsorship can be used to attract financing at extremely generous rates, improving the firm’s financial position

if a stock goes up far enough and its management is astute, it can use the “Chinese dollar”, or puffed value, to buy economic value elsewhere at a discount

The standard of investment behavior for passivists as well as activists should be, “Worry about the investments you made, that you shouldn’t have,” not, “Worry about the investments you should’ve made, but didn’t”

Advantages of a low net asset value

a company with a lower NAV might have a higher ROI

all assets come with encumberances; sometimes having a lower NAV relative to a competitor with higher NAV can result in greater ROI because the higher NAV requires more maintenance and other costs to keep it current, even when not actively productive

Wall Street sponsorship

“sponsored security” is an issue that is recommended and/or purchased by people in the financial community who are able to lure or influence others to acquire that security

important for those interested in immediate performance or timing or in owning a highly marketable, actively traded security

buying poorly sponsored or unsponsored equity securities has its advantages for long term investors because this is typically where bargains are found

The trading assumptions versus the investment assumptions

Much advice about how to invest is given from the perspective that the market knows more than the individual investor, and thus should be heeded accordingly

Convertible securities

issuers of convertibles are frequently second-rank companies who include convertibility to “sweeten the deal”

Limitations on comparative analysis

the goal is not completeness, but “good enough”; time and knowledge are at a premium

“good enough” is the standard for measuring market and business performance; no one can be best all the time or own all the resources in the world

Chapter 11, Finance and Business

Heavy Debt Load

high debt can be viewed as a reason to purchase a stock, especially in a bull market, because many equate it to aggressive mgmt

another reason high debt can be an asset is if the debt was acquired at attractive terms and competitor firms are not able to replicate such financing

Large cash positions

can be a sign of unattractiveness when:

entrenched, non-raidable mgmts refuse to make productive use of funds

where mgmt refuses to use funds to undertake necessary expenditures

watch out for companies that appear strong financially but operationally are weak because they have not invested properly in their businesses

Diversification versus concentration

some enterprises excel with a singular focus

others benefit from diversification

the jury is out

Management incentives

management expenses and salaries are paid before all other securities

management looting is generally not a problem in larger firms, but it is widespread enough that no security holder should assume there is a community of interest between mgmt and security holders

Advantages of highly cyclical companies in competitive industries

the adversity and challenge of these industries tend to attract highly talented mgmt

they also tend to be well financed and relatively liquid because they can’t afford not to be

Going public and going private

What a business is worth as a private enterprise is different from what it is worth as a public enterprise

A private company can go public by selling its own equities, or it can sell out for cash to a company that is already public

Many times a public company is worth far more private than public so it will go private by purchasing up shares for cash

a company repurchasing stock is, in effect, going private when it does so

Who runs most companies?

Myth is that they’re run by their directors; day-to-day reality is they are run by their mgmt

Consolidated versus consolidating financial statements

Sometimes, due to cross-ownership of securities held within a senior organization, the common equity of a child company can take a “de facto” status as a senior security within the parent organization

Negative values in owning assets

“everything’s got a price”

“I wouldn’t own that asset if you gave it to me”

Because ownership of most assets entails obligations and expense, the second statement is typically truer than the first

Chapter 12, Net Asset Values

The usefulness of book value in security analysis

book value is an accounting number and it is limited in usefulness as any accounting number is

by itself it means little; gains significance relative to other figures and information

quantitative measure of assets; tells us “how much”

Book value as one measure of resources

the amount of resources a company has to create future earnings is a good indicator of future earnings power; book value measures available resources

corporate buyers tend to focus on book value as an indicator of how they can redeploy newly acquired resources

important in calculating ROI and ROE

Book value as one measure of potential liquidity

opportunities to create tax carry-backs can occur when a common stock is selling at a steep discount from brick-and-mortar book value and the business has been paying high tax rates

useful when a profitable business is available for acquisition at a price well below net asset value as shown on the tax records

IRS can end up providing a substantial amount of the cash needed to finance the acquisition

Book value analysis as a competitive edge

most stock traders focus on short-term earnings, which is reflected in market prices

focusing on large high-quality asset values as an indicator of good future earnings could give an investor an edge as these will not be reflected in high market prices

changes in earnings and P/E ratios can be sudden and violent; changes in book value, however, tend to be gradual

Limitations of book value in security analyses

does not, in and of itself, measure the quality of a company’s assets

high-quality means approaching being down free and clear of encumberances

high-quality means the business has a mix of assets and liabilities that appear likely to produce high levels of operating earnings and cash flows

high-quality means assets tend to be salable at a price that can be estimated accurately

Chapter 13, Earnings

Wealth or earnings?

Generation of reported income is one way to create wealth

another is creating unrealized appreciation

another is realizing the appreciation that has been created

Reported income generation is the least tax sheltered way to grow wealth; creates incentive for asset-conversion

Private company mgmt tends to minimize reported income to minimize tax burden; public company mgmt tends to maximize to enjoy higher stock price

allows investor to realize gains through selling and borrowing

allows the company to issue stock for cash or to acquire other companies

The long-term earnings record

In fundamental analysis, special attention should be given to the importance of a favorable long-term earnings record

The major component of NAV for most publicly owned businesses is retained earnings

Earnings record is extremely important for a strict going-concern analysis

Judging the quality of an issuer is another situation where a strong long-term earnings record is important to the analysis

“Parsing” the income account

The static-equilibrium approach

looks at current earnings and the earnings record as principal factors in market price determination

market prices within an industry tend toward equilibrium– a stock out of equilibrium could be a reason for buying or selling

important in i-banking world, where new issues are commonly priced at lower than typical multiples as a marketing tool

The dynamic-equilibrium model

uses past and current record of current earnings as a base for estimating future earnings

projected increase is then used for predicting a future stock price

Various definitions of earnings

what accountants using GAAP report them as

what accountants using GAAP report them as, as measured by overall performance, including extraordinary items and discontinued operations

the increase in value of a business (incl stockholder distributions) from one period to the next; ie, changes in NAV

the increase in the ability to make stockholder distributions over and above actual stockholder distributions without reducing actual invested capital

the increase in the ability to make payments to all security holders, not just equity holders, during a period

the increase in ability to improve future sales, accounting profits and/or cash flow during a period

use caution when an expanding business’ earnings are not “real” because they can not finance their own growth without being acquired, ex, Parliament brand cigarettes from small private company Benson and Hedges

common stock is worth the sum of all the dividends expected to be paid out on it in the future, each discounted to its present worth

criticism: only apply in a tax-free world where the reason for owning stocks is to receive dividends and the reason for all corp activities was to pay dividends

instead, more realistic to say that common stock held by noncontrol stockholders is worth the sum of all the net after-tax cash expected to be realizable in the future from ownership of the common stock, with such net cash coming in the form of cash disbursements from within the company (dividends, liquidations) or from without (stock purchasers, lenders accepting stock on margin)

Modigliani and Miller

as long as mgmt is thought to be working in the best interests of the shareholder, retained earnings should be regarded as equivalent to a fully subscrubed, preemptive issue of common stock, and therefore that dividend pay-out is not material in the valuations of a common stock

criticism: no evidence that mgmts share a “community of interest” with stockholders

mgmt, if they are responsive to stockholders, tend to focus on the interests of holders that will bring the best benefits to mgmt

Graham and Dodd

in the vast majority of companies, higher common-stock prices will prevail when earnings are paid out in dividends rather than retained in a business

criticism: emphasis should be on which stock — low dividend payer or high dividend payer — is more attractive to which type of investor

Cash dividends as a factor in market performance

ceteris paribus, a low dividend payer is better for an investor seeking market appreciation rather than cash-casrry

lower dividend companies tend to sell at lower prices, thus they tend to be more attractive buys

a company whose common stock is available at a lower price will have more room to increase its dividend; dividend increase record is important for some in valuing stocks

lower dividends translates to higher retained earnings and thus improved financial position over time

countervailing argument: high-dividend payers tend to be better buys because a high payout ratio means mgmt is more attuned to the desires of most outside stockholders

stockholders can be hurt by companies paying out high dividends long after it is wise for them to do so

Graham and Dodd view is valid in the short-run but seems to make less sense in the long-run

The placebo effect of cash dividends

dividends increase in importance for securities holders insofar as they lack confidence in their outlook or mgmt or in the reliability of disclosures

dividends are a hedge against being wrong

Cash dividends and portfolio management

Dividends increase in importance with the shareholder’s need for immediate cash income from his portfolio

didivends become a negative factor when the shareholder wants a tax shelter or has no need for income and has confidence mgmt will successfully reinvest retained earnings

securities with a high cash return can be attractive due to positive cash-carry

Cash dividends and legal lists

cash dividend income is a legal or quasi-legal necessity for many securities holders

Cash dividends and bailouts

the ability to convert assets to cash is a key consideration for many buyers for control purposes; always key for outside investors

assuming an investor has no control over a company whose common stock he has invested in, eventually he will want the opportunity to convert into cash

The goals of security holders

most owners of senior securities are interested solely in cash income

in contrast, some equity holders can be interested in cash return (dividends or cash sale of shares) but many are interested in earnings return

Chapter 15, Shareholder Distributions, Primarily from the Company Point of View

Cash dividends or retained earnings

“proper” dividend payout policy should be made from the point of view of the corporation, not the stockholder

dividend payouts are a residual use of corporate cash and company requirements for cash in other areas have primacy

dividend policy should be dictated by company needs for funds for expansion as well as for margin of safety

companies should retain earnings whenever they have profitable ways to deploy it– this is not determined by the price of their stock as proclaimed by the stock market

high dividends can be used by mgmt to create a higher stock price and thus protect the mgmt from raids

Distributions of assets other than cash

can create a taxable event with no cash to pay it

Liquidation

any payment by a corporation to its shareholders is a form of liquidation

in truth, there is no such thing as liquidation in any meaningful sense, but rather asset-conversion

Stock repurchases

receipts of cash are taxed on a capital-gains rate only

benefits:

corporation benefits because cash requirements on future dividends are reduced

if buy-ins are of massive size, investors may be forced out of the company at a price much lower than corp reality, even if at a substantial premium to market prices

possible conflicts with insiders who might want to purchase shares, appearance of payoffs to insiders who want to sell

Chapter 16, Losses and Loss Companies

Quality considerations and tax-loss companies

an organization suffering economic losses can be attractive from the POV of asset-conversion acquisitions if:

the resources employed by the company can be put to another use so losses are stemmed

the business lacks overwhelming amounts of indebtedness

it has available to it tax benefits growing out of the former losses

On accounting and income

tax benefits, for accounting purposes, are treated as extraordinary items

however, these benefits have very real cash consequences and can generate substantial future earnings when reinvested, regardless of how they are accounted for

Be wary of acquiring equity securities of the encumbered firm

the danger in investing in loss corporations is that they have become so encumbered that there is no practical way to invest safely and profitably

“big-bath” writedowns should be viewed as nonrecurring from the standpoint of judging the stewardship of the mgmt

Commercial banks’ portfolio losses

principal earnings assets of banks are investments in loans to customers and investments in securities, notably UST and munis

when interest rates rise, the banks’ loan book falls in value, so they purposefully take losses to reinvest in higher yielding securities

The “turned the corner” theory

many times people will invest in small, losing companies with no record of profitability with the belief that when they “turn the corner” the market will substantially appreciate their new growth records

risky

hard to predict the future of uncertain businesses

new issues normally not priced on bargain bases relative to corporate reality

these securities rarely prove attractive from the FIA

Chapter 17, A Short Primer on Asset-Conversion Investing: Prearbitrage and Postarbitrage

prices paid for common stocks for investment purposes are different from prices paid for control of businesses

Four types of “do-able” asset-conversion activities that might be spotted with the FIA

more aggressive employment of existing assets

merger and acquisition activities

corporate contests for control

incorporated and domiciled in states where there are no strong anti-takeover statutes

share ownership is widespread or blocks are locked up in private transactions

possible low will of mgmt to resist a takeover

absence of impediments to takeover, such as being in a regulated industry

no antitrust problems

there do not appear to be important people or institutions, such as customers, employees or suppliers, who could harm the takeover target by terminating relationships

going private

Postarbitrage

occur after an asset-conversion event when securities owned by public shareholders remain outstanding

sometimes when an offer to acquire securities is announced and less than all the shares tendered are accepted, arbitragers tend to dispose of masses of stock they have accumulated shortly afterward, depressing market prices

important to avoid mgmts that have a predatory predilection

postarbitrage securities tend to be relatively unmarketable or not marketable at all

one important rule of thumb: acquire shares at prices two thirds or less than control shareholders paid in the recent past to obtain control

Disclaimer/Disclosure

No commentary on this site should be considered as an offer to buy or sell any security. No commentary on this site should be construed as investment advice or an offer to provide investment advice. I may or may not be an investor (long or short) in any of the securities I discuss.